How to find the right funding? Types of debt on the road to profitability

“Having debt is healthy. It shows that a company wants to get a better return on its capital.” According to Pedro Agudo, Head of Risk & Data at BBVA Spark, the key is that this debt is appropriate for the company, both in terms of form and time. This is one of the main conclusions of the last BBVA Spark Open Talk, entitled ‘Types of debt and the road to profitability‘, and a key idea for entrepreneurs, since access to funding is one of the most common challenges for them, as the Entrepreneurship Map prepared by South Summit confirms.

There are many ways to access funding, but what type of funding is the most appropriate at each point in the business lifecycle? As a startup begins to scale up and wants to reach the next level of its business plan, a thorough analysis of the available options is required, including from investors. “Before looking at the requirements for access to venture debt, the first thing I look at is whether the business plan makes sense,” explained Christhi Theiss, who moderated the session and highlighted the leading role of alternative debt formulas, such as venture debt, in a financial context characterised by the cooling of investment.

This trend is illustrated by the example of two of the startups invited to the latest BBVA Open Talks: Twinco Capital and Fracttal. The former, a supply chain finance fintech, recently closed an investment round of up to €50m in debt with BBVA Spark, while the latter, which has developed intelligent software to manage the maintenance of assets with greater sustainability, safety and efficiency, also closed an investment round of €9.4m with the support of BBVA Spark.

A type of debt for each stage of growth

Both Twinco Capital and Fracttal have used different types of financing depending on the stage of the business. “There is a type of debt for each stage of the company,” said Twinco Capital CEO Sandra Nolasco at the event. In the beginning, the company used convertible debt – a loan that can be converted into equity – with investors who were already involved in the project “to avoid having to go to the market.” This type of investment allows the company to obtain the funding to address short to medium-term challenges, while capturing part of the upside of future valuation. “This instrument is interesting when it comes from investors whose  interests are aligned with those of the company. It is a form of investment that makes sense at times when the valuation is too arbitrary (e.g. at the beginning of a startup) or at times when you want to bridge a round because you have relevant milestones that you need to achieve in a relatively short period of time,” she added.

In later stages, Twinco turned to senior debt, a type of debt issued by an agent with the highest possible credit rating. However, because the business is based on being able to transfer capital to other companies, its focus is on what is known as a warehouse facility. This is a form of funding that consists of a loan from a financial institution to a company whose assets, goods or commodities are used as collateral for the loan. “If you have assets that generate cash flow and are a better risk than the startup, you can use them as collateral. A very efficient way to do this is to put them into a vehicle and borrow against that vehicle. That way, the investors have direct access to the cash flows generated by those assets as a source of repayment. In other words, the collateral for the investor and the main source of repayment is the asset itself,” Nolasco explained.

Venture debt to mitigate equity dilution

The journey was different for Fracttal, which raised its first round of venture capital funding in 2018. “We did a mix of equity and venture debt because we wanted to raise capital that would allow us to continue to grow, but with minimal dilution to execute the business plan, increase our growth rate and thus be able to pursue other valuations,” CEO and co-founder Christian Struve explained.

Venture debt helps mitigate the dilution process by being a loan that consists mainly of debt to be repaid with interest, plus a small portion to acquire equity in the company. For Fracttal, it is a suitable instrument when the business is already reliable and predictable. “Unlike equity, venture debt has to be repaid and that has to be in your cash flow,” said Fracttal’s CEO.

At the company’s current stage, Struve says this type of debt helps them be more disciplined in allocating resources and prioritising projects: “It’s about having a company that can meet its payment obligations without putting pressure on cash flow. It allows us to access capital, but at the same time to achieve the business plan with a runway and sufficient revenue.”

Debt to support a viable business plan

A good team and strategic planning are essential to achieving the right economic balance. As part of this assessment, Pedro Agudo believes it is also important to analyse unit economics in high-growth companies, i.e. metrics to monitor revenue, costs and profitability per unit of product sold. “Consistency between how you generate revenue and how you finance it is key,” he stated.

Meeting funding requirements and choosing the right debt will also depend on experience and how the team is made up. Twinco Capital’s CEO believes that debt requires more prior knowledge: “If the founding team has no financial experience, equity will be easier and debt will be more complicated, especially when it comes to raising ‘good’ debt that fits your business and your timing beyond the amount and price.

Struve, CEO of Fracttal, added that having a great finance team and proving that your business is viable is also a must: “Maybe debt doesn’t have as thorough a due diligence process as equity, but sometimes it’s about weighing up what stage I’m at and whether we’re prepared to increase investment where I need resources to do things properly.”

While there is no single route to the right funding, high-growth companies approach their funding search with versatility and preparation. While there may be a different but appropriate type of funding at each stage of a company’s life, debt must always be sustainable to drive the business model forward. In the words of Pedro Agudo, Head of Risk & Data at BBVA Spark: “Debt should not be there to make your life impossible, but to help you.”